Module 6 of 6 — Founders' Agreements and Startup Legal Setup

Shareholder Rights, SHA Essentials, and Anti-Dilution

Reading module · approx 14 min

The Shareholders' Agreement (SHA) is the principal legal document governing the relationship between founders and investors. It is negotiated at the time of external investment and governs how the company is managed, how future fundraising decisions are made, and how and when shareholders can exit. Understanding the SHA's essential provisions is a survival skill for any founder.

What an SHA does and does not do

The SHA is a private contract between the shareholders. It supplements the articles of association (which are a public document filed with the ROC) with rights and obligations that the parties do not want publicly disclosed. The SHA is NOT a public document; the AoA is. Key SHA provisions are typically also incorporated into the AoA to ensure they are binding on future shareholders.

Board composition and information rights

Investors typically seek board representation proportional to their ownership stake. The SHA specifies:

The total size of the board
How many seats each party has the right to nominate
The quorum for board meetings (requiring investor nominees to be present)
Information rights: quarterly financial statements, annual audited accounts, monthly management accounts, right to inspect books

Protective provisions (reserved matters)

Investors negotiate for certain decisions to require their consent, regardless of how many shares they own. Common protected matters include:

Issuing new shares or convertible instruments (altering the cap table)
Amending the SHA or AoA
Incurring debt above a specified threshold
Selling, licensing, or mortgaging material IP
Changing the principal business
Declaring dividends
Related party transactions above a threshold
Acquisition of other companies
Winding up

Anti-dilution protection

Anti-dilution provisions protect investors against future fundraising rounds at a lower valuation than the round at which they invested (a "down round"). The two primary forms:

Full ratchet: the investor's conversion price is reset to the new (lower) round price, regardless of how much was raised at that price. This is very investor-friendly and harsh on founders.
Weighted average: the conversion price is adjusted based on a formula that considers both the price and the volume of shares issued in the down round. Broad-based weighted average (which includes all shares and options in the denominator) is more founder-friendly than narrow-based (which excludes options from the denominator).

The weighted average anti-dilution formula is the market standard in India. Full ratchet is rare and a red flag from an investor that is not founder-friendly.

Drag-along and tag-along rights

Drag-along: allows a majority of shareholders (or a specified majority including investors) to compel all other shareholders to sell their shares in an acquisition. This prevents a minority shareholder from blocking a sale that the majority wants to complete. Drag-along rights are essential for facilitating exits — no acquirer wants to buy a company where a minority shareholder can hold the deal hostage.

Tag-along: allows minority shareholders to participate in a sale by a majority shareholder on the same terms. If the founders are selling their shares to a buyer, tag-along allows investors to sell their shares at the same price and on the same terms. This protects investors from being left behind when founders exit.

Liquidation preference

The liquidation preference specifies the order in which proceeds from a sale or liquidation are distributed. The most common structure for venture capital:

Investors receive their investment back first (1x liquidation preference, non-participating)
After the investors receive their 1x preference, all remaining proceeds are distributed pro-rata among all shareholders (including the investors' converted shares)

A participating preference allows investors to receive their 1x preference AND participate in the remaining proceeds. "Double-dipping" participating preference can significantly reduce founder proceeds in a sale and is a deal-term that founders should negotiate against.

Right of first refusal (ROFR) ROFR is the right of existing shareholders (typically investors and the company) to purchase shares that a shareholder wants to sell to a third party, at the same price and on the same terms offered by the third party. ROFR is typically triggered before a shareholder can transfer shares to an outside buyer. It prevents unwanted third parties from buying into the cap table and gives the company and existing investors first opportunity to maintain their relative ownership positions.

Founder lock-in provisions

Investors typically require founders to be locked in for a specified period after investment: they cannot sell or transfer their shares without investor consent during the lock-in period. This is separate from vesting and operates independently — a founder may be fully vested but still locked in. Lock-in periods of 2 to 3 years are common at the Series A stage. Founders should resist lock-in periods that are longer than their vesting period or that have no good-leaver exceptions (e.g., where the investor terminates the founder).

The document stack

At a typical Series A, founders and investors execute the following documents:

Term Sheet (non-binding, outlining the key economic and governance terms)
Share Subscription Agreement (binding; governs the mechanics of the new share issuance)
Shareholders' Agreement (binding; governs ongoing governance and shareholder rights)
Amended Articles of Association (to incorporate SHA provisions as AoA articles)
IP Assignment Agreement (if not already done at incorporation)
Founder Employment Agreements (formalising founders as employees with vesting and non-compete)

Understanding each document in this stack — what it does, what it commits you to, and what it cannot be changed without your consent — is the foundation of being a legally literate founder.